AP MICROECONOMICS
UNIT #6
MARKET FAILURE/
ROLE OF GOVERNMENT
Lecture 7
Correcting Negative Externalities
Externalities and Deadweight Loss
■ Inefficiency causes deadweight loss
– Negative Externalities create efficiency
losses due to overproduction
– Positive Externalities create efficiency
losses due to underproduction
Deadweight Loss Graph 1
Deadweight Loss Graph 2
Correcting Market Failure
Does the government have to or
need to become involved?
Coase Theorem
■ Ownership of private property produces an
incentive to “negotiate away” negative
externalities
– Ownership places a price tag on the externality
and creates opportunity costs for affected
groups
Government Correction of
Externalities
■ Direct Control
– make laws (ex. EPA rules)
■ Taxation for Negative Externalities
– directly tax the related good (ex. Excise taxes
on cigarettes)
■ Subsidies for Positive Externalities
– Payments as incentives to producers or
consumers
Taxes Reduce Overallocation
■ Directly taxing the good shifts the firm’s
supply curve (MPC) to the socially optimal
supply curve (MSC) to reduce overallocation
Negative Externality: Resolving with a Tax
Price of
Aluminum
ST
Tax
S
(MPC)
Optimum
Equilibrium
DT
0
QOPTIMUM QMARKET
Quantity of
Aluminum
Copyright © 2004 South-Western
Subsidies Correct Underallocation
■ Consumers: payments to consumers would
shift the demand to the socially optimal
level at a higher price
■ Producers: payments to producers would
shift the supply to the socially optimal level
because they would be compensated for the
additional production
– Per unit subsidies are required for producers to
alter production
Positive Externality: Resolving with a Subsidy
Price of
Education
ST
Subsidy
DT
D
(MPB)
0
QMARKET
QOPTIMUM
Quantity of
Education
Copyright © 2004 South-Western
Another Solution
■ Government creates a market for pollution
– Sells pollution rights to producers on the
open market
– Rights are fixed so there is inelastic
supply
– Increased demand increases cost of the
pollution rights
– Some pollution may be necessary for
MSB > MSC
Selling Pollution Rights
Government Failure
■ Government does not always perform its
economic functions
– Gap between sound economics and politics
■ Special-Interest Effect
– Small group benefits from a government policy
while a much larger group incurs individual
losses
■ Rent-Seeking
– Groups that seek special benefits from the
government at taxpayers’ expense
Burden of Taxes
■ Taxes are imposed on the suppliers
– Increases the MC of the product
– Producers shift part of the tax burdent
to consumer
– Equilibrium quantity declines due to
higher prices
Price (Per Bottle)
Elasticity and Tax Incidence
P 14
St
12
S
10
Tax $2
8
6
4
D
2
0
5
10
15
20
Quantity
25
Q
(Millions of Bottles Per Month)
LO3
16-16
Impact of Elasticity
■ The more inelastic the demand, the greater
the tax burden placed on consumers
■ The more inelastic the supply, the greater the
tax burden placed on producers
■ Efficiency loss occurs any time there is a tax
because there is less production
– Deadweight Loss
Elasticity and Tax Incidence
P
P
Tax
Tax
St
S
Pe
St
P1
P1
a
b
P
Pb
a
S
c
b
De
Pa
c
Q2
Di
Q1
Elastic Demand
0
Q2 Q1
Inelastic Supply
Smaller efficiency loss with inelastic demand
LO3
16-18
Elasticity and Tax Incidence
P
P
St S
Tax
Tax
St
a
Pe
P1
Pa
S
b
Pi
P1
a
b
c
Pb
c
D
0
Q2 Q1
Elastic Supply
D
Q
0
Q2Q1
Q
Inelastic Supply
Smaller efficiency loss with inelastic supply
LO3
16-19
Efficiency Loss of a Tax
P
Tax paid
by
consumers
14
St
Price (Per Bottle)
12
S
Tax $2
10
8
6
4
2
Tax paid
by
producers
Efficiency
loss (or
D
deadweight loss)
0
5
10
15
20
Quantity
25
Q
(Millions of Bottles Per Month)
LO3
16-20